The markets have pulled back after a promising January, shaken by turbulence in the banking sector. It's an unwelcome sight for shareholders of retailer Target (TGT -0.70%); the stock struggled in 2022 and is now almost 40% off its high.
But is Target's decline a case of the baby being thrown out with the bathwater? Or are investors down on the stock for good reason? Here is what you need to know.
Target missed the mark in 2022
Unfortunately, Target's decline wasn't all smoke and mirrors. The company struggled with pressured profit margins throughout the year. You can see in the chart how operating margins declined substantially from long-term averages. Weaker margins caused 2022 operating income to fall $5.1 billion from $8.9 billion in 2021, a 57% year-over-year decrease.
But why? Target's fulfillment costs soared, including a rise in employee compensation and investments in fulfillment centers, combined with rising freight and supply chain costs and increased markdowns as consumer spending weakened. Put it all together, and you get earnings per share (EPS) chopped in half; Target earned $6.02 in 2022 on a non-GAAP (generally accepted accounting principles) basis, down from $13.56 in 2021.
TGT Operating Margin (TTM) data by YCharts
That context puts things in perspective; it seems fair that a stock price is halved if earnings are too. Using 2022 earnings of $6.02, the stock trades at a price-to-earnings ratio (P/E) of 26.8, still 44% higher than the stock's long-term average P/E of 18.5.
Will 2023 be better?
Management expects better operating conditions this year, estimating an additional $1 billion in operating income. For now, 2023 EPS guidance stands at $7.75 to $8.75, a pretty wide range that reflects uncertainty over the economy.
Hypothetically, I'll assume that Target beats and does $9 in EPS. The stock still trades at a forward P/E of 17.8, right about the stock's long-term average. Said differently, investors could watch the stock stagnate for another year until the business grows into the current valuation.
Meanwhile, analysts aren't quite as optimistic about Target's prospects. Long-term EPS growth estimates have faltered and now call for slight earnings contraction.
TGT EPS LT Growth Estimates data by YCharts
Could analysts be wrong? Of course! The risk for investors is that shares could trade below Target's long-term average if operating performance continues suffering. That's potentially a longer wait to receive any meaningful investment return outside the company's dividend, which yields 2.7% at the current share price.
What should investors do?
A struggling company can be an excellent investment if an investor can sniff out the cause of the problem and correctly call a turnaround. Target's struggles are well-known, and one could reasonably expect management to right the ship eventually.
The problem is that the stock's valuation doesn't yet reflect all the what-ifs that could go wrong -- even after shares have fallen 40%. Investors looking to buy shares should tread very carefully or stay on the sidelines until management shows a few quarters of clear uptrends in operating margin and resulting earnings growth.
